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The Rule Maker Portfolio, Mar. 2, 1999

TOWACO, NJ (March 2, 1999) -- Before we get started, I want to remind everyone about our new "question of the week" feature. Every Monday, we'll ask our weekly mindbender. Whoever posts the best response on our Rule Maker Strategy message board (subject: "question of the week") wins a prize. This week's winner will get an autographed copy of Rule Breakers, Rule Makers. We already have some great responses. You have until Sunday night to post your best answer to this week's question:

"What criteria should we add to the Rule-Maker scoring methodology?"

Also, the long-awaited Rule Maker spreadsheet is finally available! (Right-click this link to save the spreadsheet to your hard drive.)

Moving on... Tonight, I thought that I'd explore three of the ways in which a company can take actions related to its shares of outstanding stock -- some of these actions result in rewards to shareholders, others are merely window dressing. I'm going to discuss these in what I view as the reverse order of significance.

Stock Splits

The least significant action that a company can take with regards to its stock is the one that is viewed by many investors as one of the best pieces of news that they can get -- the announcement of a stock split. In reality, a stock split is totally meaningless. Splitting a stock is no different than taking a pizza and cutting it into four, eight, or any other number of slices, getting two tens for a twenty or playing a basketball game in four quarters as opposed to two halves. In each case, the whole has not changed. Similarly, the fundamentals of a company are unchanged after a stock split.

Oftentimes, stock split announcements cause run-ups in the price of a stock. Even more unbelievably, there are times when a company's failure to announce a stock split is given as a reason for a decline in a stock's price. My jaw nearly hit the floor when I heard one of the Talking Heads on CNBC attribute part of the reason for the decline in Cisco's(Nasdaq: CSCO) stock price after its most recent earnings announcement to its failure to split its stock. I really found it offensive to hear even speculation that the failure of Cisco to split its stock could cause its stock price to fall. This kind of statement only contributes to the almost mythical quality that stock splits have these days.

Personally, I think it would be more meaningful if members of the financial media reminded investors that in today's world it is no longer necessary to buy stock in round lots of 100 shares -- meaning that in the majority of cases, splits don't really make stock any more affordable at all. Making the stock price more affordable is probably the primary reason that companies give when they split their stock.

Of course, I can't deny that there are short-term traders that try to speculate and profit from potential stock splits. But as a long-term investor, stock splits are meaningless.

Another thing related to stock splits that is essentially meaningless in today's world is the setting of a record date when a split is announced. I regularly read questions about the treatment of stock purchased after the record date but before the effective date of the split on Message Boards throughout Fooldom. The record date for a split used to have importance when actual share certificates were usually held by shareholders. Now most shares are held in "street name." Regardless of when they are purchased, any shares purchase before the effective date will split. There is no risk that you will lose money if you buy shares after the record date but before the effective date of the split.

Dividends

The second action a company can take is to either start paying its shareholders a dividend or increase the current dividend. If you're like me and are only investing money in the market that you don't expect to need for at least the next 5 to 10 years, then you probably don't really have a big need for dividends. If that's the case and your broker allows it, then I suggest reinvesting those dividends in additional shares of stock. I will say, though, that there most likely will be a time in the future when I will appreciate the dividends that I'm paid on my stockholdings. You see, my hope is that when I do retire, the dividends that I receive on my stocks will be large enough to enable me to meet a large portion of my living expenses.

The payment of dividends also provides a means for companies to offer Dividend Reinvestment for their shareholders. As a matter of fact, a number of the companies that we hold in this portfolio, including Intel, Pfizer, Schering-Plough, and Coca-Cola offer fee-free dividend reinvestment plans (DRiPs). I don't mind nominal dividends like the one that Intel (Nasdaq: INTC) pays for just this reason. However, as a general rule, dividends are a relatively inefficient way for a company to get cash to its shareholders. This is primarily because of the fact that dividends are taxed as ordinary income. A much more efficient way to distribute cash to shareholders is through share buybacks.

Share Buybacks

The last action that a company can offer its shareholders is the one that provides the biggest benefit -- a stock buyback. I recently read a 1996 study by Financial Management that found a company's stock rises an average of 3% the day a buyback is announced and, more importantly, by 12% more than the rest of the stock market over the next four years.

There are several reasons that a company will decide to buy back its stock. The first and best reason is that the company may feel its stock is undervalued. If management is confident that the company's stock is trading for less than the intrinsic business value, there is no better use of capital than to buy back stock. Second, when buybacks result in an increased stock price, they can also be viewed as a form of non-taxable dividends. Finally, since buybacks lead to fewer outstanding shares, the investor that holds on to her shares of stock will end up with a larger percentage of ownership in the company as a result of the buyback.

In addition, companies may also buy back shares as a means of avoiding future dilution. This is because many companies offer such benefits as stock options and stock purchase plans to their employees. Normally, these plans allow employees to purchase stock at a discount to the company's current market price. Since these plans issue new shares of stock, a company must regularly repurchase stock in order to stay even on the number of outstanding shares.

Of course, you might wonder why a company that is performing well would want to buy back shares of its stock -- even when it's not undervalued -- rather than reinvest the cash back into its business. There are times, however, when no appropriate core business projects exist for the funds, so share buybacks offer the best means of increasing shareholder value.

One last thing to keep in mind is that you should check up on your companies to see whether or not they have actually followed through with any stock buyback announcements. You can find this information by reading the Statement of Cash Flows (under Financing Activities) or the Consolidated Statement of Shareholders' Equity.

I'll be back tomorrow to discuss some of the non-balance sheet assets that help to make our companies so valuable.

Finally, be sure to share your opinion regarding the question of the week on the strategy board. Also, here again is the link for downloading the Rule Maker Spreadsheet (right-click to save to hard drive).